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CEO Pay Is an Underrated Risk to Stocks

(Bloomberg Opinion) -- As U.S. stock investors contemplate the biggest long-term risks facing the market, such as a global economic slowdown, trade tensions or rich equity prices, they shouldn’t overlook a critical one: the pay disparity between corporate bosses and workers.

In 2015, the Securities and Exchange Commission adopted a rule that required public companies to disclose the median compensation of employees and that of the CEO, beginning with fiscal year 2017. The numbers have confirmed what many suspected: Chief executives are paid tremendously more than workers.

The numbers also revealed that hundreds of the biggest U.S. public companies pay their workers less than a living wage. That’s not sustainable. As the grim pay disclosures pile up year after year, the backlash against the corporate elite will intensify. If corporate boards can’t find a better balance in their pay structure, outside forces will, and at a potentially far greater cost to companies and their shareholders.

My Bloomberg colleagues Alicia Ritcey and Jenn Zhao compiled the CEO-to-worker compensation ratios for companies in the Russell 1000 Index, which represents roughly the 1,000 largest U.S. public companies by market value, and laid them out in a superb interactive chart.

The median employee compensation for 104 of the companies, or roughly 10 percent of the Russell 1000, is below the federal poverty level of $25,750 for a family of four. That’s the number below which workers are eligible for government assistance.

In reality, the cost of living is considerably higher, and many more firms fail to pay workers an adequate wage. The Economic Policy Institute, a nonpartisan think tank, estimates that a family of four needs an annual income of roughly $70,000 to maintain a “modest yet adequate standard of living” in the most affordable U.S. locales. The median employee compensation is below that for 497 companies, or roughly half of the Russell 1000.

Meanwhile, CEOs are paid lavishly. The average CEO in the Russell 1000 received total compensation of $11.8 million during the most recent year for which numbers are available, including salary, bonus, stock grants, options and other benefits. The average CEO-to-worker pay ratio was 248-to-1. For the 104 companies whose median employee pay falls below the poverty line, the ratio is a whopping 917-to-1.

It didn’t used to be this way. The CEO-to-worker pay ratio was 20-to-1 in 1965, according to EPI. The ratio gradually swelled during the three decades that followed, climbing to 343.5-to-1 by 2000. With few exceptions, it has hovered near 300 since then. That history is a reminder that the corporate pay structure was once more balanced and can be again.

Fortunately, companies can afford to give workers a raise. Firms in the Russell 1000 posted an average profit margin of 10 percent in 2018, the highest since 1995, the first year for which numbers are available. Other measures of profitability, such as return on equity and return on capital, are also at or near record highs.

Critics of the CEO-to-worker pay ratio, such as Matthew Shay, president and CEO of the National Retail Federation, complain that the ratio is misleading because it includes part-time workers. While I agree that it would be better to exclude them, it wouldn’t change the analysis. Shay, for example, estimates that including part-time workers overstates the retail industry’s ratios by 31 percent. But even if that were true across all industries, it would still mean that CEOs were paid roughly 200 times more than the median worker, or 10 times the pay ratio in 1965. It also ignores the fact that the full-time equivalent of part-time pay would still be inadequate.

Some prominent investors have already acknowledged that the status quo may not hold. “It is not hard to imagine worsening social unrest among a generation that is falling behind economically,” Baupost Group’s Seth Klarman wrote in a recent letter to clients. “If things get bad enough, we could see taxes once again raised to confiscatory levels.”

That day may not be far off. Representative Alexandria Ocasio-Cortez of New York has proposed doubling the top tax rate to 70 percent from 37 percent. Billionaire investor Ray Dalio warned well-heeled attendees at the World Economic Forum in Davos last week that Ocasio-Cortez’s ideas are gaining adherents. And there’s no guarantee that government efforts to narrow the pay gap would stop at tax policy.

The question isn’t whether CEOs, founders and innovators deserve to be rewarded. Clearly, they do. Rather, it’s whether they share enough of the spoils with the workers who are essential to their success. Clearly, many do not. For now, companies and their shareholders are free to address that failure as they choose, but that freedom will evaporate if they continue to leave workers behind.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.